Dividend reinvestment: The what, why, and how

Dividend reinvestment is a strategy where investors use their dividend payouts to buy more shares of a company’s stock to harness the power of compounding. Dividend reinvestment plans (DRIPs) simplify the process, enabling automatic dividend reinvestment, often with lower fees and discounted prices.

Here’s what we’ll cover:

• What dividends are
• How dividend reinvestment works
• Advantages of dividend reinvestment
• Downsides of reinvesting dividends
• When dividend reinvestment is a good idea
• How to invest in dividend stocks

What are dividends?

Dividends are payments made by a company to its shareholders, typically from its profits. Not all companies pay dividends, but those that do usually issue payments quarterly, though some pay more or less frequently. Companies pay shareholders a certain amount of money per share, so the dividend amount you earn is based on how many shares you own.

Dividends come in two types: ordinary and qualified. The main difference is the kind of taxes you pay; ordinary dividends are taxed at your standard income tax rate, while qualified dividends are subject to the lower capital gains rate. The other notable difference is related to whether you own common stock or preferred stock. Holders of the latter take priority for dividend payments and often get a higher dividend yield, but they may see lower long-term growth in the value of their stock than investors who own common shares.   

If you own stock in a company that pays dividends, you have three options when you receive a payment:

• Hold the dividend in your portfolio as cash
• Take the money out of your brokerage account to spend
• Reinvest the dividend through a dividend reinvestment plan (DRIP)

How does dividend reinvestment work?

Dividend reinvestment plans (DRIPs) automatically reinvest your cash dividend earnings back into additional shares of the issuing company. There are two main types of DRIPs: those provided by brokerages, and those offered directly by the companies themselves. Both types function similarly, using dividend payouts to purchase new shares, without the need for a separate transaction. 

Keep in mind that dividends reinvested through a DRIP are still subject to taxes. This means that even though you’re using these earnings to acquire more shares, the income must be reported and taxed accordingly, just as if you had taken the money as cash.

Example of dividend reinvestment

Imagine you own 150 shares of a company that pays a $0.50 semi-annual dividend per share. You’d receive $75 when the company makes a dividend payment. By enrolling in a DRIP, that money is used to automatically buy more shares. If the stock price at that time is $30, you’d gain an additional 2.5 shares, taking the total amount of shares you own to 152.5. 

Let’s say the stock’s price has risen to $31 per share by the time you get your next dividend payment. Since you now own 152.5 shares, you’d receive $76.25 in dividends, and you’d automatically purchase about 2.46 more shares through the DRIP.

This cycle shows how DRIPs use compounding to grow an investor’s portfolio over time. Note that a reinvestment plan can sometimes result in accruing fractional shares, or portions of stock less than a full share, allowing investment in high-priced stocks with smaller amounts of money. 

Pros of dividend reinvestment plans

DRIPs have several advantages for investors looking to maximize their portfolio’s growth. These benefits range from financial gains to ease of investment.

• You may benefit from compounding: By reinvesting dividends, you’re essentially earning returns on your returns, which can significantly boost the value of your investment over time due to the power of compounding returns.
• It’s easy to automatically invest: DRIPs automate the investment process, allowing your dividends to be seamlessly reinvested without the need for manual intervention, saving time and effort.
• You might pay lower fees: Many companies’ DRIPs offer reduced or even zero transaction fees, which means more of your money goes into investing rather than paying charges.
• You could get discounts on stock prices: Some companies offer discounted share prices through their DRIPs, giving you more value for your reinvested dividends.
• You can earn more dividend income in the future:  As the number of shares you own increases through a reinvestment plan, you stand to receive higher dividend payouts in the future, enhancing your income potential from these investments.

Cons of dividend reinvestment plans

While DRIPs offer several benefits, they also come with certain downsides that can impact investment flexibility and portfolio balance.

• Reinvesting schedules can be rigid: DRIPs often follow a set schedule for reinvesting dividends, which can limit your ability to make strategic investment decisions based on current market conditions.
• Rules and benefits of DRIPs vary: Each DRIP comes with its own set of rules and benefits, which can vary significantly between plans offered by companies and brokerages. This requires investors to stay informed and adapt to potential variations.
• DRIPs can undermine diversification: Continuously reinvesting dividends into the same stock can lead to an overconcentration in a single investment, potentially reducing the diversification of your portfolio.
• Your portfolio could grow imbalanced: As your holdings in dividend-paying stocks increase through reinvestment, your portfolio may become disproportionately weighted towards these stocks, which could misalign with your overall investment strategy.
• You might buy more of poorly performing stock: If a stock’s performance declines, automatically buying additional shares through a DRIP means you could inadvertently increase your stake in a losing investment, compounding potential losses.

When is dividend reinvestment a good idea for you?

Opting for a DRIP can be a smart move if you’re focused on long-term growth and are comfortable with the associated risks of reinvesting in the same stocks. DRIP investing is particularly beneficial if you believe in the future potential of the company and are looking to compound your investment over time. And if you’re focused on a long-term investing strategy, your reinvested dividends can help you grow your portfolio with less hands-on management.

On the other hand, automatic dividend reinvestment might backfire if the stock is consistently underperforming or if buying new shares would overly concentrate your portfolio in one sector or stock. In such cases, reallocating dividend payments to different investments like other stocks, mutual funds, or exchange-traded funds (ETFs) might better align with your strategy. 

How to get started with dividend reinvestment

DRIP investing can be a strategic move for investors who want to put their passive income from dividends to work building their portfolios. 

Open a brokerage account

In most cases, you’ll need to open a brokerage account in order to purchase stocks. There are many types of brokerages, from brick-and-mortar firms where you might work with a financial advisor or a broker to build your portfolio to online brokerages where you can manage everything yourself or use a robo-advisor. 

Research dividend-paying stocks

Once you’ve opened a brokerage account, it’s time to look for stocks that pay dividends and evaluate their potential. Certain types of stocks are more likely to provide stable dividend income and potential growth in share price.

• Blue chip stocks: These are shares of large, established, and financially sound companies that have a long history of reliable performance.
• High-yield dividend stocks: These stocks offer higher dividend yields compared to the average stock, though they may come with higher risks.
• Dividend aristocrats: Companies in the S&P 500 that have consistently increased their dividend payouts for at least 25 consecutive years are often seen as providing steady profits for investors. However, there are usually fewer than 100 such companies, so your options are limited. 

When considering dividend stocks, pay attention to several key factors:

• Dividend yield: This is the dividend per share, divided by the stock price, indicating the earnings you get for each dollar invested.
• Dividend payout ratio: This ratio shows what portion of the company’s earnings is paid out as dividends, which can indicate the sustainability of the dividend.
• Company financials: Assessing the overall financial health of the company, including earnings stability and growth prospects, is crucial to ensure it can continue paying dividends.

Purchase shares

Once you’ve settled on the stocks you wish to purchase, it’s time to become a shareholder. Stock prices are determined by supply and demand, and some of the most popular dividend-paying stocks have high share prices. But don’t worry: many brokerages allow you to buy fractional shares, so you can invest even if if a single share is more than you can afford. You’ll receive a proportionate share of dividends when they’re paid, even if you don’t own a full share. 

Enroll in a dividend reinvestment plan

The most common way to get started with dividend reinvestment is to enroll in a DRIP through a brokerage. Using your brokerage’s DRIP is simple and convenient, since you just have one plan to deal with and everything is managed in a single place. You might also have the option to automatically reinvest your dividends in different assets, which can help avoid the pitfalls of undermining diversification. Brokerages might also offer ETFs that contain dividend-paying stocks, allowing you to invest in a basket of securities with some built-in diversity. The downside is that brokerages don’t usually offer a discount on DRIP shares.

If you’d rather participate in an individual company’s DRIP, you’ll have to take a slightly different route and overcome some hurdles. First, not all dividend-paying companies offer a DRIP, so you’ll need to do some research. Additionally, you’ll likely need to buy shares through the company’s direct stock purchase plan and register your name on stock certificates instead of using a brokerage of your choice; this process can take some legwork. Keep in mind that there may be enrollment and other fees, and you might need to use a third-party transfer agent when you want to sell your stock. And if you enroll in DRIPs with multiple companies, you’ll have to keep track of all the different plans and paperwork yourself. 

Keep track of your portfolio’s performance

Dividend reinvestment helps put your investing strategy on autopilot, but that doesn’t mean you should completely set it and forget it. Check in on your portfolio once a month or quarter to see how your investments are performing, review earnings reports from the companies in which you own stock, and ensure your asset mix still aligns with your strategy. 

Amplify your investment strategy with dividend reinvestment

Embarking on a dividend reinvestment strategy through a DRIP can be a powerful tool for long-term investment growth. By automatically reinvesting dividends, you harness the power of compounding, potentially increasing the value of your investment over time. However, it’s important to regularly review your portfolio, perhaps with the help of your financial advisor, to ensure that your dividend stocks are performing as expected and to rebalance your holdings to maintain alignment with your investment goals. 

Stash’s automated investing options simplify the process, with a Stash Managed Portfolio that reinvests your dividends and automatically rebalances your portfolio to ensure your investments continue to align with your long-term financial objectives.

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